Is reforming box 3 a wise plan?

Current issues related to economics, (responsible) investing, pensions and income: every week an APG expert gives a clear answer to the question of the week. This time: macroeconomist and expert strategist Charles Kalshoven on whether reforming box 3 is a sensible plan. “The short answer is: yes.”

The current tax system in the Netherlands is complex and perceived as unfair on certain points. This applies to box 3, for example. Due in part to sharply declining interest rates - until a few years ago -  many taxpayers are in a situation where the calculated, notional return is nowhere near equal to the return actually earned. Thus, they pay tax on income they did not even have.

It is up to outgoing State Secretary for Taxation Marnix van Rij, who is leaving political The Hague after his term of office, to do something about this. Consequently, he has a completed proposal ready for reforming box 3, so that the actual return on assets from 2027 will be taxed. How wise is this reform?

Notional return

“How did it work? Until 2020, the box 3 tax assumed a fixed asset mix. With fixed portions for savings and investments, depending on the amount of assets. This was the same for everyone, even if someone only had savings. Because of this system, people with savings, with low returns, paid too much tax. After all, interest rates were low or even negative in recent years. Investors with high returns paid too little. The Supreme Court labeled this unjust,” Kalshoven notes. The unfeasibly high notional return of 4 percent particularly attracted criticism. “A capital gains tax of 1.2 percent amounts to the same as a 30 percent capital gains tax on a 4 percent return. But that would be less likely to lead to angry voices and attempts to challenge it legally. There are other countries that have a capital gains tax, the important thing is that the tax should be proportional and fair.”

Reforming box 3 is a good thing, Kalshoven believes. “The old system was no longer tenable. And we now have a temporary system that includes crazy things. Saving with a bank is now fiscally much more attractive than investing in safe government bonds. That’s weird.” When it comes to reforming the Box 3 calculation, Kalshoven believes you can go one of two ways. “You can go to a simple wealth tax, which does not depend at all on your return, but on the amount of wealth itself. It allowed you to keep the first 50,000 euros tax-free. And above a certain amount you could apply a higher rate, say 2 percent or more. That way you counteract wealth inequality. Not unimportant for tax morale; it helps if the tax system is seen as fair. There is also an economic case. If you tax wealth more heavily, you need less distortional taxes on labor.” 

Actual return

The second option is taxing actual returns, which is the proposal of the outgoing administration. “That option comes closest to what people think is fair, but it has practical problems with illiquid investments like real estate. Suppose you have a house in addition to your own, which you inherited, for example. If house prices then rise sharply, you suddenly owe thousands of dollars in taxes. You likely don’t just have that lying around; your assets may be mostly tied up in that house. For stocks and bonds, of course, it’s all a bit easier. Increases in value and returns are easy to determine, and when necessary, the assets can be quickly monetized.” The main rule was therefore chosen: tax actual returns according to a capital gains system. Kalshoven: “This system taxes earned and unearned income from assets and allows for the deduction of related expenses.”

Property, such as houses and art, is subject to a capital gains tax as an exception to the main rule. The development of value for these assets is taxed upon actualization (read: sale). For the first (vacation) home in Box 3 involving primarily owner-occupancy, a flat rate of return applies. “Instead of tax-free assets, a tax-free income from assets will apply. This feels fairer than the current system. After all, no returns or low returns also means there is no wealth tax on them.”

European Convention on Human Rights

The cabinet proposal is also in line with the Supreme Court ruling, which said in late 2021 that the way wealth is taxed in Box 3 violates the European Convention on Human Rights (ECHR). According to the ruling, only the actual return on assets may be taxed.

“But whatever system you choose, there will always be some injustices. Most people start their careers with little financial capital and a lot of human capital (future earning power). By retirement age, it’s the other way around. But take an elite athlete, for example, who converts almost all of their human capital into financial capital in the first 10 to 15 years. That composition of wealth over time matters. On balance, it means they pay more tax; first on earned income, then on accumulated wealth. At least, if the top soccer player doesn’t move to, say, Monaco. Incidentally, I don’t think Dutch people will lose sleep over taxes on top athletes. A survey last year showed that Dutch people feel it is fairer if someone becomes rich through an inheritance than through professional soccer.”

Unstable income

Kalshoven also touches on the instability of tax revenues. “By taxing actual returns, the government is less able to estimate what comes in. If the stock market crashes, the treasury won’t suffer with a notional return, with actual returns, of course. So, the government balance will move more with the economy and the stock market. In the long run it will not make much difference to the treasury, but the intermediate fluctuations will be greater. Of course, this should not lead to panic soccer and short-term cuts. It helps to budget trend-wise and account for those larger fluctuations in advance.”

When APG’s macroeconomist considers all the pros and cons, he answers the question of whether reforming box 3 is wise with a “yes”. The old system was not legally tenable anyway; the new proposal is an improvement. Justice is served by taxing actual returns on liquid assets. And for illiquid assets, practical solutions have been chosen. That sounds like something that should be workable for the Tax Administration.”

A higher tax rate for large assets is also being discussed globally, including at the World Economic Forum in Davos. Read Thijs Knaap’s opinion on this in this article.